President Dilma Rousseff has pledged massive new government spending programs while eschewing the difficult but essential structural reforms needed to sustain long-term progress, the author points out.

Wednesday, April 30, 2014

Perspectives

Brazil And Mexico: Hope Or Hype?

Until the so-called “secondary legislation” in
Mexico is finalized, it is not clear whether the energy reform will meet the
high expectations of industry observers and financial markets.

BY ROGER F NORIEGA AND FELIPE TRIGOS

During the last three decades, most of Latin America has
benefited from important gains in the consolidation of democratic institutions
and implementation of orthodox economic policies that have tamed
hyperinflation, reined in debt, and liberalized trade. Of course, Venezuela,
Cuba, and other countries are dramatic exceptions to this regional progress.
Even in countries that generally have chosen a more responsible course,
however, recurring bouts of populist policies make it harder for them to reach
their full potential.

For example, the region’s bellwether economies—Brazil and
Mexico—are routinely hailed for their growth spurts and unquestionable
potential. However, inconsistent policies have put sustained and substantial
economic growth just out of their reach. A burgeoning middle class in both
countries has increased the demand for more economic opportunity; better jobs;
low inflation; and efficient, accountable government— raising the stakes for
leaders hoping to meet these expectations.

In the long run, sound policies are good politics. Fresh
evidence of failed statist models in neighboring countries in Latin America has
reinforced the lesson that prosperity can be achieved only through responsible
macroeconomic policies, fiscal discipline, and a growing and dynamic private
sector. Unless elected leaders commit fully to policies that favor free market
solutions, they will not be able to deliver the economic opportunities their
people require. (…)

BRAZIL: TRIUMPH OF HOPE OVER EXPERIENCE

For the last 20 years, economists have charted Brazil’s
steady climb in the ranks of world economies. Under a series of democratically
elected presidents, but beginning especially with former President Fernando
Henrique Cardoso, who served from 1995 to 2003, successive Brazilian
governments have implemented orthodox macroeconomic policies that succeeded in
ending the country’s historical boom-and-bust cycles and taming inflation.

Growing opportunities swelled the ranks of middle-class
consumers, and income-transfer programs have helped millions lift themselves
out of poverty. In 2005, the country earned a seat at the then–G-8 (Group of
Eight) dialogue and was hailed as an example for the developing world. Indeed,
Brazil’s relative stability in the wake of the global financial crisis of
2007–08 appeared to validate the most optimistic forecasts for the country’s
economic future.

The windfall from a commodity boom fueled by Chinese
consumption and the discovery of vast deep-water oil deposits in 2007 buoyed
the Brazilian economy, lowered unemployment, and filled the government’s
coffers. The downside to the country’s apparently boundless prospects was that
then-president Luiz Inacio “Lula” da Silva was under no pressure to invest his
considerable political capital in a reform agenda that most experts say was
needed to make Brazil more competitive and unlock its full potential.

Writing in the journal Americas Quarterly in
mid-2012, University of Connecticut professor Peter Kingstone argued that
Brazil had grown too dependent on the commodity boom. By 2012, he noted that
Brazil’s commodity exports accounted for 14 percent of gross domestic product
(GDP), compared to 6 percent in the 1990s.

Indeed, in 2012, the
tide began to turn. Weakening Chinese demand for commodities and other raw
material imports hit the Brazilian economy hard, with growth sliding from 7.5
percent in 2010 to 2.3 percent in 2013.

The slowdown also exacerbated contractions caused by the
government’s more statist economic policies. Widespread urban demonstrations in
June 2013, sparked by public transportation rate hikes and the government’s
perceived indifference to the needs of most Brazilians, were a sobering
reminder that Brazil’s economic trajectory continues to be a work in progress.

Many economists have identified unfinished business in
Brazil’s reform agenda, including improving government efficiency and
accountability, taming costly public pensions, simplifying the labyrinthine
federal and state tax systems, liberalizing the labor code, removing arbitrary
obstacles to doing business, and attracting foreign capital and technology into
the promising energy sector. Brazil’s political leaders would do well to renew
consideration of these reforms to spur more robust growth.

The Brazil Economic Survey for 2013, published by the
Organization for Economic Cooperation and Development (OECD), echoed the need
for cutting public expenditures and debt, reforming the tax and labor codes,
and continuing to manage inflation.

It also recommended education reform that focuses on
improving overall quality as well as entrepreneurship and vocational worker
training.

Yet, in reaction to slowing growth and popular
discontent—and facing reelection in October 2014—current President Dilma
Rousseff has pledged massive new government spending programs while eschewing
the difficult but essential structural reforms needed to sustain long-term
progress.

A dramatic example of the prime need for reform is the
current management of state-owned oil company Petrobras. Even with the
prospects for vast new oil deposits, Brazil’s petroleum sector has failed to
reach its potential and is under unrelenting pressure from politicians to
generate the revenue needed to fund the state’s social welfare programs. In
recent years, Brazil has failed to attract the capital and technologies needed
to exploit its resources because of the nationalist ground rules the government
has imposed on investors. Domestic content rules and onerous requirements to
enter into partnerships with Petrobras have discouraged many international oil
companies from entering the Brazilian market.

Still, Petrobras remains the government’s cash cow. Even
as its profitability and stock prices have declined, Petrobras is required to
finance growing social spending. For example, the Brazilian Congress recently
passed a law earmarking 75 percent of oil royalties for education and 25
percent for health care. In addition, Petrobras also is required to divert
revenue to import foreign oil to satisfy domestic consumption.

Although Brazil’s social welfare programs—such as the
Bolsa Familia cash transfers—have helped 50 million people out of poverty, they
have added to Petrobras’s financial burden. They also exact a significant and
growing portion of the national budget. According to the Financial Times,
a 2012 study by the Brazilian government found that the number of young people
(aged 15 to 24) not working or in school has increased since 2009, leading some
to ask whether government transfer programs have contributed to a culture of dependency.
The Times piece also reported that the slowing economy even led some to
question the 11-year-old Bolsa Familia program.

Another significant drain on the government’s finances is
its pension fund, which entitles persons over 54 years of age to receive a
pension of 70 percent of final pay. Brazil spends 3 percent of its GDP on
survivors’ pensions, although OECD countries spend an average of less than 1
percent for such benefits. Furthermore, Brazil spends a staggering 11.3 percent
of GDP on public pensions, a percentage just below that of Greece.

Brazil’s public education programs present another
serious problem. The government spends 5.6 percent of GDP on public
education—more than the average of OECD countries—yet the quality of education
ranks very low. Although education outcomes have proven to be unsatisfactory,
Rousseff’s election-year agenda proposes to increase education spending to 10
percent of GDP, the highest rate of any nation in history.

Inadequate infrastructure is another obstacle to Brazil’s
growth. Much attention is being paid to Brazil’s costly renovation and
construction of venues and other facilities that will host the 2014 FIFA World
Cup and the 2016 Summer Olympics. These expenditures stand in stark contrast to
the significant infrastructure deficit countrywide that inhibits key sectors of
the economy. In contrast to the global average of 3.8 percent, Brazil spends only
1.5 percent of GDP on infrastructure.

This underinvestment has resulted in inadequate
transportation networks and inefficient ports, which have hampered commerce;
raised shipping costs; and undermined the profitability of agriculture, mining,
and other industries that depend on the export market.

Overcoming these obstacles is essential for Brazil to
sustain healthy growth rates and realize its aspiration of becoming a global
economic power. High current account deficits, high inflation, and possible devaluations
could further complicate Brazil’s predicament. A Bulltick Capital emerging
markets research analyst warns, “Interventionist and erratic policymaking,
capital controls, fears of China’s deceleration, and declining commodity prices
have affected the Brazilian economy.”

Whoever
wins Brazil’s October 2014 presidential election will be expected to tackle the
politically tough challenges to gradually liberalize the Brazilian economy to
produce broad economic growth to take the country to the next level.

MEXICO'S MOMENT?

Unlike
other countries in the region, Mexico’s robust economic growth in recent years
was not heavily dependent on the commodities boom. Instead, it has resulted
from the economic policies implemented during the administrations of
Presidents Ernesto Zedillo (1994–2000), Vicente Fox (2000–06), and Felipe
Calderón (2006–12).

After
decades of devaluations, high current account deficits, excessive inflation
rates, and deficit spending, Mexico was finally consolidated as one of the most
stable economies in the world; for example, international reserves increased
from $35 billion in 2000 to $163 billion in 2012. Throughout the last
decade, Mexico signed 44 free trade agreements (more than any country in the
world) and established itself as one of the world’s leading exporters of
manufactured goods and the third most important commercial partner for the
United States.

In
the final year of Calderón’s administration, the economy grew 3.9 percent.
During 2013, the first full year under president Enrique Peña Nieto, Mexico’s
economy contracted and grew only 0.9 percent. Most
of this slowdown came in the first half of 2013 and could be attributed
primarily to sluggish US growth. However, Peña Nieto’s populist campaign and
initial budget proposals may have sent negative signals on crucial taxing and
spending issues. In his first year, Peña Nieto steered important education and
energy reforms through a divided Congress, but his tax reform plan imposes a
disproportionate burden on the productive sectors of the economy and will not
likely generate sufficient revenue to cover significant new social spending.

Furthermore, although Mexico’s economy attracted more
than $33 billion in foreign direct investment in 2013, reports from Mexico’s
Central Bank (BANXICO) suggest that this figure is expected to decrease by 22
percent in 2014. Also, according to BANXICO, between January and September
2013, Mexico experienced a capital outflow of $26 billion, which accounts for
15 percent of Mexico’s international reserves. The outflows are apparently due
to investor uncertainty about whether Peña Nieto will vigorously implement his
ambitious reform agenda to liberalize key sectors of the economy.

The same reports that predicted Brazil’s takeoff also
noted that Mexico was headed toward becoming the seventh largest economy in the
world. Under its two previous administrations, these positive assessments were
substantiated by financial discipline, deft management of the 2007–08 global
financial crisis, responsible monetary policies, robust trade policies, and
historic levels of foreign direct investment. It remains to be seen whether
these healthy economic conditions can be maintained if Peña Nieto gives into
the demand for traditional populist formulas that look to the state for
solutions and increased social spending.

To his credit, Peña Nieto came to office promising
comprehensive reforms that would improve Mexico’s long-term economic
performance. Under El Pacto por México (the Pact for Mexico), the president and
leaders of the country’s three major parties agreed to implement a series of
important initiatives, including reforms of the education, telecommunication,
financial, and energy sectors. The ability of this administration to win
approval of so many reforms from a fractious Congress is impressive,
particularly in light of the groundbreaking nature of most of these reforms. Of
particular importance are the tax overhaul and energy reform.

The fiscal reform adopted last fall is not without its
critics. In addition to raising taxes on the wealthy to help finance increased
social spending, the new tax regime will extract more revenue from the
productive, salaried middle class. Worse yet, the new taxes will not keep up with
new spending—the equivalent of 4 percent of GDP—that was adopted to compensate
for the economic slowdown. The combination of high taxation and rising
government expenditures could threaten the steady growth that Mexico had
achieved in recent years.

One renowned expert on the Mexican economy,
Raúl Aníbal Feliz of the Center for Research and Teaching in Economics,
criticized the tax reform as “mediocre” and warned that it would undermine
Mexico’s economic stability.

He noted that the reforms do not improve the efficiency
of tax collection and that taxes remain too high for an economy the size of
Mexico’s. He predicted that the government would have to either cut spending or
revisit the tax structure in the near future.

Another economist, Hector Villarreal, director for the
Center for Economic Research and Budget in Mexico, recently warned, “The
government is increasing its debt and disregarding economic growth, and this,
in the long run, may end up in a deficit of 10 percent of GDP at the end of
this administration.”

On the other hand, Peña Nieto’s energy reform took
specific aim at the long-standing “third rail” of Mexican politics: opening up
the oil sector to foreign investment. Although the president’s original
proposal was cautious, the ensuing legislative process produced a
transformational package. The ruling Institutional Revolutionary Party (PRI)
and the center-right National Action Party (PAN) approved a substantial,
sweeping plan for restructuring Mexico’s poorly managed energy sector. The
language also proposes to reduce the influence of the powerful oil workers
union by eliminating its representation on the company’s board.

In addition to improving performance, other reforms seek
to improve the financial management of the state-run oil company Petróleos
Mexicanos (PEMEX). For example, a key provision will reduce the amount of
revenue that PEMEX funnels into the government’s budget from more than 50
percent of its revenue to no more than 4.7 percent. This will allow PEMEX to
reinvest what it needs in exploration, operations, and maintenance to improve
profitability.

Moreover, a “Mexican Petroleum Fund” will channel funds
to a sustainable pension fund for PEMEX employees, provide a reliable source of
funding for infrastructure (30 percent of revenues), and invest in PEMEX’s
human capital (10 percent of revenues) to encourage postgraduate education and
specialization for the company’s workers.

Although the privatization of Mexico’s oil industry was
never seriously considered, significant opportunity exists today for improving
the sector’s performance. If implemented thoroughly, energy sector reforms can
be transformational in fueling Mexico’s economic development and making the
country into an energy powerhouse. The next several years will be pivotal in assessing
whether PEMEX will succeed in adopting modern policies and practices,
particularly by welcoming private investment, reducing government interference
and taxes, and taming the influence of powerful and corrupt labor unions.

Until the so-called “secondary legislation” is finalized,
it is not clear whether this energy reform will meet the high expectations of
industry observers and financial markets. Implementation of the laws and
regulations, which will determine the depth and breadth of the energy reforms,
is still being hammered out between the PRI and the PAN. For example, the
secondary legislation would define the management structure and the terms for
the exploration, exploitation, refinement, and transportation of oil and gas.
It also will establish the parameters for private investment and for the
collaboration of private companies in ventures with PEMEX. Unfortunately,
recent partisan rancor has delayed negotiations on this critical legislation.

Roger F.
Noriega is a former assistant secretary of state for Western Hemisphere affairs
(Canada, Latin America, and the Caribbean) and a former U.S. ambassador to the
Organization of American States. He coordinates the Latin America program of
the American Enterprise Institute (AEI). This column is based on an excerpt
from a recent AEI Latin America Outlook report.